Don't Get Caught in a Bull Market 'Trap'

Stock and bond prices continue to be volatile, as investors try to sort out the future direction on the economy and money managers reposition their portfolios.

Not surprisingly, on days that equity prices have rallied, the Wall Street "cheerleaders" have commented on the resiliency of the U.S. economy. Meanwhile, money managers have told their clients to add to their portfolios by purchasing "bargain-priced" stocks.

Yet, these same "cheerleaders" and money managers have been urging the Federal Reserve to cut interest rates in an effort to stimulate the economy. In addition, many of these money managers have recently been investing heavily in "defensive" stocks in the Consumer Staples, Healthcare, and Utilities sectors — in stocks of companies that tend to have slow, steady growth and that become more popular during economic contractions because they provide products necessary for everyday life; these sectors have been the top-four performing sectors of the market over the past month.

(Note: Although "defensive" stocks tend to hold up well during periods of slowing economic growth, they tend to lag the market during economic expansions — they tend to under-perform other sectors when portfolio managers expect the economy to expand).

As long as portfolio managers continue to rotate their holdings out of growth sectors and into the "defensive" sectors mentioned above, and individual investors try to figure out whether to add to their stock portfolios or to exit the equities market, stock prices will likely continue to be volatile.

You should therefore be careful to not get caught in a "bull trap". A "bull trap" is a situation in which stock prices have temporarily rebounded, even though they have been trending lower. During these situations, some investors expect stock prices to continue rising, when in fact they are just about ready to resume their recent declines. And, with the recent slowdown in consumer spending and rising claim for unemployment benefits, we think the "path of least resistance" for stock prices is clearly down.

Earlier today, the U.S. Department of Commerce released its latest estimates for second-quarter GDP, which showed the U.S. economy grew at an annualized rate of 4 percent during the second quarter of this year. Although the Wall Street "cheerleaders" were quick to praise the "surge" in GDP, a closer look at the composition of this report clearly shows the economy isn't nearly as strong as some money managers would have you believe.

For example, the bulk of the gains in GDP came from three areas — government spending on national defense (the war in Iraq), net exports, and non-residential construction spending. Meanwhile, consumer spending, which accounts for 70 percent of GDP, slowed dramatically, with spending on durable goods falling to an annualized rate of 1.7 percent, versus 8.8 percent during the prior quarter. Consumer spending on non-durable goods actually declined during the quarter, while the growth in total personal consumption expenditures slowed to 1.4 percent, from 3.7 percent in the first quarter and 3.9 percent during the fourth quarter of 2006.

Although we welcome the increased fiscal stimulus (government spending), we think most people would agree that spending on the war in Iraq will likely slow in the months ahead. And, while net exports added to the rise in second-quarter GDP, they did so largely because of the significant decline in the U.S. dollar, which has very serious inflation implications.

Lastly, we note that the growth in non-residential construction spending is probably not sustainable, as businesses are likely to reduce their investments in the construction of office buildings and industrial complexes going forward. (Note: Contracts for the construction of these types of facilities are generally signed six months to a year before construction actually begins. With consumer spending continuing to slow, we expect non-residential construction spending to fall sharply within the next six months).

So, as I've warned you on numerous occasions in the past, you can listen to the Wall Street "cheerleaders" who try to suck you back into buying stocks, or you can look for ways to profit from the slowdown in consumer spending.

Oh, by the way, Sears Holdings — the largest U.S. department store company — announced earlier today that its second quarter profit declined 40 percent, as its same-store sales fell 4.1 percent, including a 4.3 percent drop for Sears stores and a 3. 8 percent decline for Kmart.

But, not to worry — there's an ETF whose investment returns correspond to twice the inverse of the daily performance of the Dow Jones U.S. Consumer Services Index, which is comprised of holdings in Sears, as well as holdings in numerous other retailers that are experiencing deteriorating operating results.

Stock and bond prices continue to be volatile, as investors try to sort out the future direction on the economy and money managers reposition their portfolios. Not surprisingly, on days that equity prices have rallied, the Wall Street "cheerleaders" have commented on the...